Why Google Became Alphabet

The company that yesterday was known as Google is now a collection of separate companies, owned by a new holding company called Alphabet. The “Google” brand is the largest of those companies, and it includes search, advertising, maps, apps, YouTube, and Android. The company’s less related endeavors – the biotech research project Calico, the Nest thermostat, the fiber internet service, the “moonshot” X lab, Google Ventures, and Google Capital — are all now separate companies housed under Alphabet.

Why? And will it work?

The Google founders are already being called Warren Buffetts-in-training. But as always, the company defies easy comparison. Google is not becoming Berkshire Hathaway, at least not exactly. It’s trying out something else entirely. Largely in an attempt to placate investors while preserving the founders’ unique theory of what their company is.

The restructuring is clearly a response to Google’s stagnant share price and investor unease. My argument has long been that Google’s current theory of value creation is essentially to funnel its vast profits from the search and advertising business into the hiring of strong talent, and then to give employees wide latitude to explore and pursue whatever they wish. This is embodied not only in the pattern of rather unrelated investments and acquisitions, but in policies about hiring, salaries, and 20% free time.

Investors have been uneasy about this strategy, but Larry Page and Sergey Brin have also composed a corporate governance regime that insulated them from much shareholder pressure for change. Eventually, with growth in search advertising slowing, investors’ dissatisfaction manifested itself in a stagnant stock price. And in recent months the company has taken steps to rein in some of its investments, slowing growth in expenses, and also tightening the reins on the 20% free time policy. These were the beginnings of a shifting direction at Google.

Analysts had their own problem with Google’s structure: its bundle of businesses was extremely difficult for them to evaluate. The primary challenge for analysts has been that the performance of the main business was not transparent—the financial returns of the search engine and advertising business could not be observed separately from the investments in all of the new businesses. The new structure ensures that there will be, at a minimum, independent accounting numbers produced for the Google business, and perhaps for the others as well.

Investors will inevitably push for more. The market’s response has so far been positive, with the stock price up 6%. And I suspect it will also have a longer-term performance impact, as greater transparency of both its cash flows and investments prompts greater discipline and accountability. But I doubt this move will fully pacify the uneasy investor. While this new organizational form increases transparency, that transparency only further illuminates the disconnect between Alphabet’s various businesses. It simply highlights the question of why the various businesses are bundled together. Investors are still buying the whole collection of projects, only now they’ll be able to see clearly just how much search advertising is subsidizing the rest.

As for the comparison to Berkshire Hathaway, there are some parallels. Berkshire Hathaway is a publicly traded company that is run like a private equity firm. It, like Alphabet, is a portfolio of very unrelated businesses. However, the important distinction is that Berkshire Hathaway’s businesses are generally cash producers and Berkshire’s task is to improve on the cash they already generate. Alphabet will be more like a cash cow coupled to a venture capital firm, investing in early stage and in some cases highly capital-intensive new ventures.

Berkshire Hathaway has assembled a group of investors who are confident in its theory of value creation. That’s the challenge that Google-as-Alphabet still faces. Who wants to simultaneously invest in a search engine, longevity research, thermostats, and drones? The new structure will make that investment proposition more transparent, but the company still needs to convince investors, as Berkshire has, that their theory of value creation makes sense.

Todd Zenger is the N. Eldon Tanner Professor of Strategy and Strategic Leadership and Presidential Professor at University of Utah’s Eccles School of Business. His recent book, Beyond Competitive Advantage: How to Solve the Puzzle of Sustaining Growth While Creating Value (Harvard Business Review Press, June 2016) explores how value creating corporations compose corporate theories that guide their ongoing growth, including acquisitions. You can download a free chapter at ToddZenger.com.